13.2 Exchange Rate Determination
4 min read•august 14, 2024
Exchange rates play a crucial role in international finance, affecting global trade and investment. Understanding how they're determined is key to navigating the complex world of foreign exchange markets and making informed financial decisions.
Several theories explain exchange rate determination, including , , and . These theories, along with economic factors like inflation, , and , help us grasp the forces shaping currency values in our interconnected global economy.
Exchange rate determination theories
Main theories
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- Purchasing power parity (PPP) theory suggests exchange rates are determined by the relative purchasing power of currencies, influenced by relative price levels in different countries
- Interest rate parity (IRP) theory posits that the difference in interest rates between two countries determines the exchange rate, as investors seek higher returns by investing in countries with higher interest rates
- Balance of payments (BOP) theory asserts that exchange rates are determined by the supply and demand for currencies, influenced by the flow of goods, services, and capital between countries (trade balances, foreign investment)
Deviations from theories
- Deviations from PPP can occur due to transportation costs, trade barriers, differences in product quality, and other factors preventing perfect market integration
- Deviations from IRP can occur due to transaction costs, political risks, and differences in the perceived creditworthiness of countries
Economic factors and exchange rates
Macroeconomic indicators
- : Countries with higher inflation rates tend to have weaker currencies, as their purchasing power declines relative to countries with lower inflation rates
- Interest rates: Higher interest rates typically attract foreign investment, increasing the demand for the domestic currency and causing its value to appreciate
- Economic growth: Strong economic growth often leads to currency appreciation, as it attracts foreign investment and increases the demand for the domestic currency (emerging markets)
Political and fiscal factors
- Political stability: Political instability can lead to currency depreciation, as investors lose confidence in the country's economy and seek safer investments elsewhere (Venezuela, Zimbabwe)
- : High levels of government debt can lead to currency depreciation, as investors become concerned about the country's ability to repay its obligations (Greece, Argentina)
- : Central bank actions, such as quantitative easing or changes in interest rates, can significantly impact exchange rates (US Federal Reserve, European Central Bank)
Purchasing power parity
Concept and theories
- Purchasing power parity (PPP) is the idea that the exchange rate between two currencies should equal the ratio of the price levels in the two countries
- theory suggests the exchange rate should equalize the price of a basket of goods in two countries
- Relative PPP theory focuses on the rate of change in price levels rather than absolute price levels
Law of one price
- The , which underlies the PPP theory, states that identical goods should have the same price in different markets when expressed in a common currency
- Example: If a widget costs 1.25 per €1 for the law of one price to hold
Applications and limitations
- PPP is used to compare living standards across countries and to determine whether currencies are over- or undervalued
- Limitations of PPP include differences in consumption patterns, trade barriers, transportation costs, and the presence of non-tradable goods and services (haircuts, housing)
Interest rate parity and implications
Interest rate parity theories
- Interest rate parity (IRP) is the condition where the difference in interest rates between two countries equals the expected change in the exchange rate between their currencies
- (CIRP) theory suggests the forward exchange rate should equal the spot exchange rate adjusted for the interest rate differential between the two countries
- (UIRP) theory posits that the expected future spot exchange rate should equal the current spot rate adjusted for the interest rate differential
Arbitrage and market efficiency
- IRP implies that investors cannot earn profits by borrowing in one currency, converting it to another currency, investing at a higher interest rate, and then converting back to the original currency at the forward rate
- If IRP holds, the foreign exchange market is considered efficient, as any potential arbitrage opportunities are quickly eliminated by market participants
Implications for international finance
- IRP helps explain the relationship between interest rates, inflation, and exchange rates, which is crucial for understanding international capital flows and investment decisions
- Deviations from IRP can create opportunities for carry trades, where investors borrow in low-interest-rate currencies and invest in high-interest-rate currencies, potentially earning profits if exchange rates remain stable (Japanese yen carry trade)
- Central banks and policymakers consider interest rate differentials and their impact on exchange rates when setting monetary policy and managing foreign exchange reserves
Key Terms to Review (15)
Absolute ppp: Absolute Purchasing Power Parity (PPP) is an economic theory that suggests that in the long run, exchange rates between two currencies will adjust to reflect the relative price levels of a basket of goods and services in the respective countries. This concept connects exchange rates to inflation and purchasing power, indicating that a currency's value should equal the price of a specific set of goods in different locations.
Arbitrage: Arbitrage is the practice of taking advantage of price differences in different markets for the same asset to generate a profit. This strategy ensures that prices converge to their equilibrium level, as arbitrageurs buy low in one market and sell high in another. By doing so, arbitrage plays a crucial role in maintaining market efficiency across various financial instruments, currencies, and securities.
Balance of Payments: The balance of payments is a comprehensive record of a country’s economic transactions with the rest of the world over a specific time period, including trade in goods and services, capital flows, and financial transfers. It serves as an essential indicator of a nation's economic standing and influences exchange rate determination by reflecting how much money is entering and leaving a country. A surplus indicates more money coming in than going out, while a deficit shows the opposite.
Covered Interest Rate Parity: Covered interest rate parity is a financial theory that states the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. This relationship ensures that investors cannot achieve arbitrage profits by exploiting interest rate differentials when foreign exchange contracts are used to hedge risk. It connects the returns from domestic and foreign investments, ensuring that currency fluctuations do not allow for guaranteed profits without risk.
Government debt: Government debt is the total amount of money that a government owes to creditors, resulting from borrowing to cover budget deficits or finance public projects. This debt can influence a country's economic stability, interest rates, and exchange rates as it reflects the government’s fiscal policies and ability to manage its finances.
Inflation Rates: Inflation rates measure the percentage change in the price level of goods and services in an economy over a specific period. This metric is crucial for understanding economic conditions, as it influences purchasing power, interest rates, and investment strategies. In finance, inflation rates play a key role in the valuation of financial instruments like swaps and impact exchange rate dynamics, as they affect currency strength and international trade competitiveness.
Interest Rate Parity: Interest rate parity is an economic theory that suggests the relationship between interest rates and exchange rates should lead to equal returns on investments in different currencies when adjusted for risk. This concept connects the foreign exchange market and the determination of exchange rates, asserting that if two countries have different interest rates, the currency of the country with the higher interest rate should depreciate in the future, offsetting any potential gains from the interest differential.
Interest rates: Interest rates represent the cost of borrowing money or the return on investment for saving. They are usually expressed as a percentage of the principal amount over a specified time period. These rates are crucial because they influence economic activity, investment decisions, and the overall financial system's health.
Law of one price: The law of one price states that in an efficient market, identical goods must have only one price when expressed in a common currency. This principle is fundamental to understanding how exchange rates are determined, as it helps ensure that arbitrage opportunities are minimized and prices align across different markets.
Market Efficiency: Market efficiency refers to the extent to which asset prices reflect all available information. In an efficient market, securities prices adjust rapidly to new information, ensuring that it is impossible to consistently achieve higher returns than the overall market through expert stock selection or market timing.
Monetary policy: Monetary policy refers to the actions taken by a nation's central bank to manage the money supply and interest rates in order to achieve macroeconomic objectives such as controlling inflation, maximizing employment, and stabilizing the currency. These policies play a crucial role in influencing economic activity and can have significant effects on exchange rates, making them a vital aspect of economic analysis.
Political Stability: Political stability refers to the enduring state of a government or political system where there is consistency in governance, low levels of civil unrest, and a lack of significant upheaval or change. This stability is crucial as it fosters economic growth, encourages investment, and affects exchange rates by influencing investor confidence in a country's economy.
Purchasing power parity: Purchasing power parity (PPP) is an economic theory that compares different countries' currencies through a market 'basket of goods' approach. It asserts that in the absence of transportation costs and barriers, identical goods should have the same price when expressed in a common currency, which helps in understanding exchange rates and the foreign exchange market.
Relative Purchasing Power Parity (PPP): Relative PPP is an economic theory that suggests that the rate of change in the exchange rate between two currencies over time is proportional to the difference in inflation rates of the two countries. It helps to understand how currency values adjust in relation to price level changes, providing a way to forecast future exchange rates based on expected inflation differentials.
Uncovered Interest Rate Parity: Uncovered Interest Rate Parity (UIP) is a financial theory that suggests the difference in interest rates between two countries will equal the expected change in exchange rates between their currencies. This means that if one country has a higher interest rate than another, its currency is expected to depreciate in the future to offset the higher returns on investments. UIP indicates that investors will not earn a riskless profit from interest rate differentials due to currency movements.